The recent sharp correction in markets all over the world has surprised many investors.

Most investors believe that the main Central Bank of the world, the Federal Reserve can only influence the market via Interest rates. This is naive at best, since they control the generation of new Federal Reserve Notes that function as the United States Dollar. The creation of fresh money serves to dilute the amount already in circulation and serves as a hidden tax popularly called inflation. "Fighting Inflation" is just a euphemism for printing just enough money to absorb all the wealth creation within that monetary system.

The Basis of Economics

Antal Feteke recently published an essay The Last Contango in Washington where he describes one of the little understood secrets of Economics - basis. In a discussion about a a grain elevator operator he hints at the method the grain elevator operator has to use to maximize his profit. The method is the key to profitable trading of markets:

The grain elevator can only hold so much grain. He has only so much capital. To be profitable, he has to spend his capital on storing the grain that will sell at the highest price in the future. The difference between the cash price with which he buys at harvest time when grain is plentiful and the futures price when supplies are sold out of inventory constitutes his profit. To maximize his profit he must use his capital to store the grain that is likely to be most scarce in the future.

Applying Basis to Trading in Markets

Trading stocks, bonds, forex and gold is the same. You, the investor have limited capital. You want to hold stocks, bonds or commodities that will sell for the highest price (in terms of everything else, not just dollars) in the future. In other words, you want the best basis as an underpinning of your purchase.

Most people who will read this essay in the USA, cannot imagine valuation of a good in other than dollars and anything other than dollars as money. However even a casual examination will show that it is not just dollars that function as money - stocks, bonds, foreign currencies, gold, silver, wheat and oil, just to name a few all serve as a store of value, are liquid and tradeable for each other. In fact, not many people store value in dollars - since it is guaranteed to inflate and loose value relative to all those things just mentioned.

If you consider just the playing field between stocks and USD "cash", when stocks "go up", the stock market is saying that, relative to dollars, stocks will be a better store of value or likely to sell for a higher price in the future.  When a crash or correction happens in the stock market, there is a sudden *demand* for dollars, which causes the value of the dollar to rise relative to stocks and thus commodities as well.

Now this is complicated by the fact that there are other currencies and stock markets traded in those currencies.

Consider the until-recently-very-hot Bombay stock market. It is denominated in Rupees. Rupees are issued by the Reserve Bank of India. A similar analysis to the above applies. However, this is complicated by the fact that foreign investors, notably USD investors need Rupees to purchase stock on the market.

The Permanent USA Trade Deficit

Lets take the country India as an example. India needs USD to purchase oil and other commodities. It cannot print USD. It has to sell goods and services to the United States to obtain USD to purchase oil. India thus needs to run a trade surplus with the United States in order to obtain the dollars to buy oil, which is burnt, and the process repeats.

In selling goods and services to the United States India competes with other producers such as China, Japan, in the far east. To remain competitive in price, the Reserve Bank of India has to ensure that the Rupee depreciates at least as fast as the USD. So when the Federal Reserve creates more money that would lower the ratio between the USD and Rupees, the RBI prints up more Rupees to counter this.

The Bank of China does the same with Yuan. Since Indian and Chinese goods compete in price based in United States Dollars, a competitive devaluation ensues and both countries create more Rupees and Yuan than needed to offset the rise in circulation of the USD. 

This process is quite simple - the RBI or the BoC absorb the influx of dollars into their countries, purchase US T-Bills, and issue their currency against these "Foreign Currency Reserves".

International Capital Flows - Corporations that are Economic Migrants

Any company that produces goods has to compete with all other companies that produce similar goods. This competition is the basis of a free market and is what produces the cornucopia of products that are available in the private sector. The company that makes it better, cheaper, faster - wins.  So does the end consumer.

When the influx of goods from the far east entered the US market starting in the 70s and 80s, it caught American manufacturers by surprise. The goods were often of superior quality - Japanese cars, for example. They were cheaper - lower labor rates, the absence of socialist trade unions and the ongoing competitive devaluation of the currencies in those regions meant that manufacturers that moved their operations to these regions could produce cheaper, often better and faster.

This resulted in the massive Foreign Direct Investment era of the last two decades and the massive surge in the stock exchange values in the Far East.

In the meantime, mutual funds and other entities that were siphoning American wages into the stock market had to adopt whatever strategy that increased shareholder value. They started investing internationally. Funds arose that specialized in "emerging markets".

All this massive capital flow, would ordinarily cause an appreciation in the value of the currencies of the countries where this wealth was being invested. However, the competitive devaluation policies of the central banks in those regions saw to it that their currencies were nominally tied to the USD.

Have Your Cake and Eat it Too

This was a bonanza to the Fed. There was an unlimited sink of dollars into the Far East. It was a bonanza for the American Government - they could print up dollars for their military and socialist enterprises at will, with little consequence. The nations of the far east sent material tribute in the form of goods for freshly printed dollars and this kept a lid on price inflation while monetary inflation was used to tax the world.

It lead to interventionist policies in the Far East, as the American Government saw that it was in their interest to continue this game. In the meantime, the people of America had to adapt and move to service industries, fed either by debt creation of new USD or directly via government jobs and contracts. The American Economy became a giant socialist wealth re-distribution scheme for the loot via inflation and the trade deficit from the rest of the world.

Cheap Money and The Tech Boom

All the newly created dollars first rush into the stock markets in the United States. Companies arose to feed of this flow - the creation of even plausibly profitable companies in the future was hungrily snapped up by investors who responded to the huge influx of USD by trading it for shares. The unsustainable boom of economically unsustainable companies ended in the tech bust, and the outflow of dollars from the stock market was absorbed by the real estate boom.

 

This huge creation of dollars has stratified the economy in the United States. Those that hold capital - "investors" - struggle to find a place to invest their money to retain their relative wealth.

A full analysis of this in beyond the scope of this article.
Let us return to the examination of the recent stock market corrections around the world.

Ending Irrational Exuberance

It has been alleged that there is a Plunge Protection Team (PPT), that is secretly propping up stock markets in the USA. It is alleged that there have been significant efforts to suppress the gold price. If you think this is hokey-pokey, ask Ron Paul.

Many commentators have also warned that the Central Banks might re-allocate their foreign currency reserves into Euros and into Gold. This has certainly started to happen - this widens the deficit as dollars fail to return as purchases of Treasury Bills.

It is therefore in the interest of the Federal Reserve to fight this trend, and to cause the relative value of the USD, for a time, to go up against stocks both domestic and foreign, against foreign currencies, and against commodities, notably gold and oil.

If the Federal Reserve has a mechanism, and it has access to several, to contract the money supply or simply stop its growth, it will cause major ripples in the stock and commodity markets.

If the fabled PPT simply stopped feeding money into the market, it would correct sharply downward. Most pundits think that the only mechanism the Federal Reserve has is the Interest Rate. This is laughable. If one of the other mechanisms, such as a two week cessation in creation of new USD was implemented and not announced, it would cause a sudden contraction of liquidity, especially in the currencies of the Far East as they try desperately to adjust to the new regimen.

The ensuing correction in domestic stocks will cause a demand for USD in the United States. The ensuing correction in foreign stock markets would cause institutional investors to sell and want out of the foreign currency and back into USD, causing USD to rise relative to other currencies. This would be payback time for those disloyal central banks that exited the USD into other currencies. Leveraged speculators in commodities would have their hands forced to sell these commodities.  A timely dose of fresh bullion selling would accelerate a drop in the gold price. Watch out for that coming sharp rise in interest rates.

We believe all this has happened. The charts below tell the tale.

The Dow

A drop in the Dow is a sure sign that the money wizards at the mythical PPT have turned off the spigot for a month or so. Since the Federal Reserve no longer publishes the M3, we have to guess. Notice, that the DOW corrected below the 200 DMA line and is now bouncing up. The spigot is back on.

Gold

The sharp correction in Gold seems to have been timed after the master wizards cut off Iran from purchasing gold in Switzerland. It has been reported that Iran purchased over 250 tonnes of gold in the run up to the correction.

DOW/Gold

In case you were wondering, now or the near future is the time to exit stocks and buy gold. Despite the drop in the DOW, gold dropped further, aided by a timely extra plop of gold into the market by the usual surreptitious means. This chart shows that the price of the DOW in ounces of gold has reached a PEAK or is about to reach a peak. A better opportunity to exit the Dow and enter gold has not been around since mid March. Remember all the talk about basis?

The Bombay Stock Exchange (BSE)

The massive correction in the Indian Stock Market has brokers praying to their trading terminals.

The BSE vs Gold

Lucky for the Indians... Those who missed getting out of the BSE stocks and into Gold, should be happy. The Federal Reserve has provided a buying opportunity to preserve your wealth in GOLD  - despite the BSE correction!

Gold or Silver

Those of you in the know about precious metals, know that Silver has a much bigger upside that Gold. NOW is the time to sell gold and buy silver. Silver has recently been amazingly cheap in terms of gold. We can predict that a ratio of 60 ounces of silver to an ounce of gold will likey never happen again in the future as markets adjust to the vanishing silver. From the Cafe [June 7th]: The empty trucks keep pulling up to the COMEX warehouses. Another 598,568 ounces of Silver was removed from COMEX on Monday. That makes it 12,784,591 ounces removed in the last 9 business days. Total stocks are now down to 107,617,368 ounces.

Oil

As you can see the liquidity squeeze has arrested the price of oil. It might fall further to test the 200 DMA line before rising again as demand falls with the decrease in wealth.

Oil or Gold?

As you can see the sharp sell off in Gold has made the price of oil in gold rise to its highest point in a few months and even pierce the 200 DMA line. Expect the trend to reverse as gold resumes its bull.

In short, preserving or even increasing your relative wealth is best done when you hold the item that will have the best future price in terms of everything else, not just in terms of USD. We believe that at this time, silver shines the brightest. The rise in the USD and the fall in stocks means that many people are now in a USD cash position.  People with capital know that a cash position is not viable as a means of preserving ones wealth.

The Federal Reserve hopes that "gold investors" have been burnt by the recent drop and that people will happily jump back into shares that are now a good buy. Insiders in companies know that profits are threatened. To be a producer, even in the Far East, producing anything is fast becoming not viable as people try and live without working by tapping into the USD spigot. When a job answering the phone at a call center pays many times more than a job producing automobile parts, you know that the death of manufacturing in its current guise is near.

There is no free lunch.

There is ample production capacity in this world, and more than enough oil. It is a fallacy of unbelievable proportions to believe that oil is a fossil fuel and we are about to run out of it. Hydrocarbons are the stuff of the universe. As my friend JP has in his email sig: "Humanity uses 345 Quads per year of fossil fuel.  Oil shale deposits hold 10 million Quads."  -Huber & Mills.

It has to be economically possible to produce. Fiat money as a measure of value is simply not viable. Any industry that does not add more than 50% in value to the goods it consumes, is doomed to die in a sea of paper as apparent profits in fiat money are really deadly serious losses when measured in a fixed monetary metal such as gold and silver.

Gold is not an investment. Gold is cash. It is accountable. It is measurable. It is fungible. Either you own it, or you don't. No money doctor in a countries capital can produce it out of thin air. Produce to earn gold, or die. Got cash?